Friday, December 18, 2009

Wenzel Flips?

A few readers want to know what I think of this provocative post by Robert Wenzel, in which he says Bernanke conned a bunch of us (bold mine):

This is big. It is going to knock for a big loop all those concerned about the inflationary consequences of the soaring monetary base. The Federal Reserve Bank of New York today released a report, "Why Are Banks Holding So Many Excess Reserves?".

Fed economists Todd Keister and James McAndrews state that while the high level of reserves in the U.S. banking system during the financial crisis reflects the large scale of the Federal Reserve’s policy initiatives, it conveys no information about the effect of these initiatives on bank lending or on the level of economic activity. This is another way of saying what I have been saying right along, watch the money supply, not the monetary base.

Keister and McAndrews explain that the buildup of reserves in the banking system is a by-product of the liquidity facilities and other credit programs introduced by the Federal Reserve in response to the crisis. They also discuss the importance of paying interest on reserves when the level of excess reserves is unusually high. But the key point they make remains that the majority of the newly created reserves end up being held as excess reserves and, therefore, the data on excess reserves provide no useful insight into the lending decisions and other activities of banks. Got that? The trillion dollars sitting as excess reserves has had no impact on the economy, and as the Fed stops it's emergency facilities, it is going to be drained. The trillion never went into the economy and never will.

If Keister and McAndrews are correct, and I believe they are, then the Fed will have little problem in ending its emergency lending facility activities. The banks by maintaining those funds as excess reserves (for whatever reason, even if it is simply to earn interest) have in reality kept those funds out of the economic system. As the Fed ends its liquidity emergency facilities they will have to pay back the borrowed funds.

The alarmists, who have thus pointed to the surge in the monetary base as a sign of soaring Fed monetary "easing" and who have been shouting about the inflationary consequences, are going to go into cardiac arrest once they see the monetary base crash when the Fed winds down its emergency facilities and the banks use the excess reserves to pay back the facility funds. The super-decline in the monetary base, as was the super-increase in the monetary base, will of course mean nothing relative to the actual money supply, which is where one should have been keeping one's eyes all along.

In a way Bernanke played a huge shell game on the global financial world. All the so called easing never happened. Let me repeat, what was touted by almost every economist in the world as the extremely loose monetary policy, didn't happen. The money never entered the system. It was a bluff. Bernanke has set us up for Crash II and few see it coming. I wouldn't want to play poker against him.

So here are my quick reactions:

(1) I think those Fed economists are wrong. I think we are going to get big-time price inflation, and when we do, people will look back at those who were blowing off a tripling of the monetary base in a little more than a year and think, "Wow, that's as inconceivable in hindsight as the people who said we weren't in a housing bubble." And incidentally, two of the people who said we weren't in a housing bubble were Fed economists at the height of the boom. How do I know? Because Robert Wenzel told his readers about it.

(2) It's true that Wenzel was the first guy I saw who was warning that Bernanke had put the brakes on M1 and M2 growth back in March or so. But it was also Wenzel who taught me that the Fed won't be able to simply reverse its injections of reserves, because the assets it purchased on the way up won't fetch the same price on the way down. I.e. the Fed can't simply reverse its actions and "suck the liquidity out of the system," because it may have seriously overpaid for a bunch of the MBS, Freddie and Fannie debt it added to its balance sheet.

So I don't view the Wenzel quotation above as a shot against me; if it is, it's only because of views that I literally learned directly from Wenzel himself.

(3) One final thing: I am going to be really peeved if everything I have been saying turns out true--namely that those excess reserves start finding their way out into the hands of the public (through various mechanisms we have been discussing on this blog), and then when price inflation breaks 10% Wenzel says, "See? M2 is up 28% year-to-date. A lot of economists were flipping out last year because of the huge monetary base, but only EPJ readers knew that the monetary base wasn't the story, M2 was. You need to read my blog to know what's up."

I think both your arguments are excellent and well reasoned, but neither you or Wenzel has convinced me in your points.

Mike in Alaska, who posted on your previous bank reserve entry, has some interesting things to say, some of which I think conflicts a bit with your assessment and the Fed report Wenzel is basing his commentary on.

So far Wenzel's commentary on the base has been pretty good in that it better fits current facts, but until I can see what happens the end of next year, I can't commit to agreeing to his "monetary base is useless to track inflation" thesis.

We have been very concerned for a long time about how the Fed will remove the money from the system since it almost certainly bought toxic assets from the big banks at too high of a price. We always say "they can't get the money out without incurring huge losses". Maybe this is the plan.

Lets say that on average, the Fed paid $.80 for $1 trillion of toxic assets and they realize it is time to take the money out of the system and they sell $1 trillion of toxic assets to the big banks at $.25 on the dollar.

OK, who suffers the $.55 loss? Is it just a bookeeping entry? Or, if the Fed takes a loss of $550 billion does the treasuury just issue $550 billion in treasuries and make the Fed whole? If so, it is just a taxpayer bailout and we are used to these anyways. So, the Fed can drain the money out of the system and they don't care if they take a loss...they saved the economy.

Or, inflation kicks in big time and drives all assets prices up. The toxic asset prices rise back up to around $.80 and the Fed sells them off at zero loss. Of course, one would have to accept that inflation effects asset prices in that scenario.

Good points Pepe. Someone asked me a few months ago, "Can the Fed become insolvent?" and my answer was, "Duuuuh, which way did he go George?" I.e. I have no idea what happens if the Fed sells off its assets and is left with $300 billion in liabilities (bank reserves) and nothing on the asset side. But, as far as the price inflation issue, that means the Fed couldn't drain out everything.

You also make a good point Pepe that moderate price inflation might reduce or even eliminate the toxicity of those MBS. E.g. let's say we have 8% price inflation this year, and then 15% price inflation in 2011. That would probably do a lot to turn around the housing market, in and of itself. (I.e. there is all kinds of other wammys that will hit it, but raising prices could help people who are underwater etc.) So maybe Bernanke could then unload things and meet halfway; he needs moderate inflation to get out of the corner he's painted himself into, but it would allow him to avoid absolute catastrophe.

I still don't see us experiencing low CPI growth for the next x years. We will end up having almost 3 percent CPI growth (even seasonally adjusted) in 2009!

It seems to me that you two are arguing the same point. Murphy is saying inflation is nigh because those reserves are going to be lent out eventually despite the Fed's best efforts, and Wenzel is saying that there will not be inflation until M2 takes off. Aren't those the same thing? I am not an economist, so I could be missing a nuance there. Is it just the difference in timeline? Murphy soon, Wenzel later?

Roso, Wenzel thinks that these reserves will not get into the money supply for two main reasons

1) A large proportion of the reserves represent loans which must be paid back

2) He is taken with argument in the cited fed paper which holds that the fed can stop the draining of the reserves by bumping up the interest they pay on them

I don't know enough about the various terms involved in the credit programs to say how strong an argument 1 is against inflation.

Argument 2 isn't all that convincing to me. The fed could up the interest they pay on reserves if they wanted stop them being drained down, but they could also boost interest rates in a recession. The important point isn't what the fed can do but what they're likely to do and I just don't see them trying to compete with market returns once things begin picking up, which is what they'd have to do to stop the reserves getting drained down.

My point is not that the Fed will raise rates to force the payback of the reserves, rather the loans are coming due, the Fed will say "Pay me" and the banks will pay with the excess reserves.

The Fed research paper is more in line with having to allow the Fed funds rate to increase IF the money owed is not at the banks that have the excess reserves. I do not agree with that part of the paper.

What if the banks can't pay back the excess reserves they hold because they are still insolvent and they've been using the excess reserves to pad their balance sheets, while the other assets they still hold continue to decline in value (and non-performing loans continue to pile up)?